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The UK's productivity puzzle

Posted on 18/04/2017

Slow productivity growth is one of the biggest topics shaping current economic discourse.

It is hard to overstate the importance of productivity in driving improvements in living standards. Since 1850, UK GDP per head has risen 20-fold, transforming our standards of living. If productivity had remained flat over that period, GDP per head would only have doubled.

UK labour productivity rose at around 2% a year from the seventies but has stagnated since the financial crisis. British productivity now remains only slightly higher than its pre-crisis peak at the end of 2007.

While weak productivity is a global phenomenon, international comparisons suggest that it is a particularly acute problem for the UK. For example, British workers are less productive than the French by a third. As a result, the average French worker could stop work on Thursday afternoon and still produce as much as the average British labourer does in a week.

Economists have provided several explanations to this productivity problem. Some argue that official data underestimate economic activity and with it potential productivity gains, largely due to problems with accurately measuring output in an information economy. Some suggest that the financial crisis has had a persistent scarring effect on output and productivity by halting corporate investment in technology. Others point out that regulatory forbearance and accommodative monetary policy have hindered the process of "creative destruction" by supporting low-productivity companies which would have otherwise failed.

Last month, the Bank of England's Chief Economist Andy Haldane added another explanation to this list. He made a compelling argument about the effect of widening divergence of productivity among firms on overall productivity growth.

His analysis of productivity across a representative panel of UK businesses shows that the corporate sector is characterised by a small minority of productivity leaders, firms that have maintained high and rising productivity both before and after the financial crisis, and a long tail of laggards - low productivity firms that have not been able to keep up with the leaders. Indeed, the data show that for more than half the firms on the panel, productivity is lower than the panel's average by at least 50%.

This divergence between firms at the frontier and the long tail of laggards has widened over the years. Arithmetically, it is this long tail that accounts for the flatlining of overall productivity since the financial crisis.

There are two aspects of this argument that are quite appealing.

First, it explains the weakness in productivity growth despite transformative changes brought about by the widespread adoption of smartphones, advances in machine learning and cloud computing among others. Perhaps, the firms at the frontier have made the most of these innovations while the rest have lagged behind.

Second, it helps establish a link between productivity and another one of today's biggest economic issues - rising inequality of income and opportunity across society.

Household incomes depend on wages, which, in turn, are dependent on the productivity of the firms people work at. Therefore, Haldane argues that the widening gap between productivity across firms could have contributed to the widening dispersion and stagnation in incomes.

The Bank's analysis of wage data supports this thesis. Haldane finds that labour productivity can explain around 60% of the variation in average pay across firms. On average, firms with 1% higher productivity reward employees with 0.2% higher pay. This makes productivity growth central to not just raising living standards but also addressing rising inequality.

So, could we boost productivity among the firms that are laggards?

Perhaps. Going back to France's example, its highly regulated labour market and high wages mean businesses have invested heavily in technology and prioritised the efficient use of labour. As a result, it has one of the most productive labour forces in the OECD (although heavy regulation and high labour costs also result in high levels of unemployment and impinge disproportionately on small and medium size businesses). In the UK, Brexit and the introduction of the national living wage have the potential to exert similar pressure on wages, incentivising businesses to invest in technology and focus on efficiency.

The UK's productivity puzzle is one of its biggest policy challenges today. While it is unlikely that one event or policy could put productivity growth back on track, measures directed at boosting efficiency among low-productivity firms could go a long way towards addressing the problem.

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